Bretton Woods, Bank Herstatt, and FedNow: The Origins of the International Payment System
Thursday, September 17, 2020

The international payment system was put together at a beautiful New England country lodge, the Mount Washington Hotel, at the base of Mt. Washington in New Hampshire, in the closing months of World War II in 1944. One of the fundamental agreements reached by the 730 delegates from 44 nations at the United Nations Financial and Monetary Conference over three weeks in July was that American dollars were convertible into gold at the fixed rate of $35 per ounce. The conference also resulted in the creation of both the World Bank and the International Monetary Fund. The so-called Bretton Woods system governed international financial transactions from 1944 until 1971 and is generally acknowledged to have provided the foundation for the tremendous economic recovery worldwide, and especially in the United States, from the twin effects of the Great Depression and the World War. But, by 1971, the fixed exchange rate and the differentials between the several Western economies put ever-increasing strains on the system, particularly as the fixed exchange rate in effect forced all participating countries to manage the value of their respective currencies in “lockstep.” By 1971, West Germany abandoned the Bretton Woods system as it refused to devalue the rapidly appreciating Deutsche Mark. The French complained repeatedly about the “asymmetrical financial system” which supported unemployment in the U.S. exceeded 6% and inflation was over 5.8%, so after high-level meetings at Camp David in August 1971, among Federal Reserve Chair Arthur Burns, Treasury Secretary John Connally, Undersecretary for International Monetary Affairs (and later Federal Reserve Chair) Paul Volcker, and President Richard Nixon, President Nixon suspended the convertibility of dollars into gold and invoking a 1970 Congressional enactment to impose wage and price controls.

The American economy reflected the costs incurred in carrying on the War in Vietnam, which did not end until 1975. In the Middle East, Arab conflicts with Israel exploded in the Six Day War of 1967 and again in the Yom Kippur War of September 1973. The Organization of Petroleum Exporting Countries (“OPEC”) had been formed in 1960 and, after defeat in the Yom Kippur War, OPEC weaponized oil by imposing an embargo that materially affected all Western economies and particularly the U.S. In these times of uncertainty an economic disruption, student radicalism had evolved from the so-called Free Speech Movement and ant-Vietnam War protesters to armed efforts to subvert social order in South America, Italy, and, perhaps most troubling, in West Germany, where the Baader-Meinhof Gang proclaimed the arrival of the Red Army Faction who carried out bomb and shooting attacks against officials and business leaders. In the midst of this turmoil stood a private bank, founded in 1955 in Cologne, West Germany. Cologne, an ancient river town on the Rhine with a monumental cathedral, was and is a bustling commercial center. The private bank, started by Ivan David Herstatt, had assets of over DM2 billion (approximately $800,000 at the then extant exchange rates) by 1974 and was the 35th largest bank in West Germany. During 1973 – 1974 the U.S. dollar experienced significant volatility. Bank Herstatt had become by then a substantial player in foreign exchange markets. Unfortunately, the bank made wrong bets on the direction of the dollar, such that by June 1974, it had DM470 million in losses, while it had only DM44 million of capital. On June 26, German regulators forced the bank liquidation. That day a number of other banks had released DM to Bank Herstatt in Frankfurt (the German financial capital) in exchange for U.S. dollars to be delivered in New York. Due to the six-hour time difference, Bank Herstatt was defunct before payment was payable in New York. The failure of Bank Herstatt was the critical occurrence leading to the formation of the Basel Committee on Banking Supervision, a standing committee of the Bank for International Settlements, and led to the efforts to create a Real-Time Gross Settlement (“RTGS”) system, which is what FedNow intends to be.

As the number of financial market transactions grew and their size increased, Bank Herstatt-like risks grew alongside. Frequently, the account of one bank is drawn against during the business day in amounts in excess of the balance in the account, but the account is brought back into a net positive position through incoming transfers that arrive during that same day. The imbalance during the business day is known as a “daylight overdraft.” Clearly, the system can only function with the regular occurrence of daylight overdrafts so long as either the banks trust their counter-parties OR some intermediary provides a stabilizing facility to support the continuous flow of transactions. In 1985, the Board of Governors of the Federal Reserve System (“FRB”) adopted policies that allowed large amounts of transfers between selected banks, allowing those banks to operate smoothly. The FRB requires those banks to hold a 10% reserve as part of maintaining their safety and soundness. In the case of daylight overdrafts, a selected bank may use some or all of its reserves to “liquidate” the overdraft, so long as the bank does one of four things:

  1. “Repays” the reserve by the end of the business day;

  2. Monitor the borrowing and transactions requiring the use of reserves;

  3. Supply collateral to the FRB to secure an as yet unliquidated overdraft; or

  4. Pay a 50-basis point fee on the overdraft amount.

Each selected bank is given a net debit cap by the FRB, which is used by the FRB to manage the risks of a failure to liquidate daylight overdrafts. Necessarily, to the extent a fully functioning RTGS system is implemented, the Herstatt-like risks inherent in daylight overdrafts will be ameliorated.

Where the U.S. Payment System Came From

In 1816, then-President James Madison chartered the Second Bank of the United States with a 20-year charter as authorized by Congress. The Second Bank provided central regulation of currency and inflation by controlling the allocation of specie (so-called “hard currency”, i.e., coins and precious metals). The number of banks in the U.S. grew from 31 in 1801 to 788 by 1837. By the 1830s, the Second Bank was under substantial attack from many sides, particularly led by President Andrew Jackson, who saw the Second Bank as elitist and oppressive to the average citizen. As a result, the Second Bank was not rechartered and was unable to assert significant authority to deal with the financial panic of 1837, when many banks failed and many depositors lost their savings. By the mid-1840s, banking had become even more complex, even as the fragmented system created risks that were not well-managed. In the economy at large, the Gold Rush in California from 1849 on, the increased construction of canal systems in the Northeast, and the building of a national railroad system, all led to economic growth. In New York City, the number of banks grew from 24 to 57 between 1849 and 1853. Banks settled their accounts once a week on Fridays by having “porters” travel from bank to bank with bags of coins (specie). But as the number of banks grew, the exchanges by porters became a daily occurrence after gathering each day for their “Porters’ Exchange” on the steps of one of the New York banks on Wall Street. The weekly accounting was often undercut by errors and sometimes by fraud.

In 1853, George D. Lyman, a bank bookkeeper, proposed that banks send and receive checks at a central location. As a result, The New York Clearing House was organized on October 4, 1853. One week later representatives of 52 banks met in the basement of 14 Wall Street and exchanged $22.6 million in checks. 14 Wall Street was later (in the 20th century) the Headquarters of Bankers’ Trust Company and of its outside law firm, White & Case, (where the author of this blog began his professional career over 50 years ago). Within 20 years, the average daily clearing exceeded $100 million. It is now in excess of $20 billion. The New York Clearing House functioned as a kind of central bank, especially in the panics of 1857 and 1893. In the wake of another panic early in the 20th century, Congress passed the Federal Reserve Act in 1913, under which the FRB was created. Thereafter the New York Clearing House concentrated on facilitating the completion of financial transactions by clearing payments. Member banks (so-called “Clearing House banks”) exchange checks, coupons, and certificates of value among themselves, and the Clearing House records the charges and credits to their respective accounts. A settlement is made at 10:00 a.m. each business day involving about three million pieces of paper.

In 1970, the Clearing House Interbank Payments System (“CHIPS”) began operations, followed by the New York Automated Clearing House (“NYACH”) in 1975 and then the Clearing House Electronic Check Clearing System (“CHECCS”) in 1992 and in 2000, NYACH became the Electronic Payment Network (EPN”). On July 1, 2004, the New York Clearing House Association changed its name to The Clearing House Association, L.L.C. (“TCH”), which continues to provide clearing services for the payment system, although now much more a computer-based system dealing with digital items as the number of paper pieces declines every year. TCH remains an entity owned by and operated for Clearing House banks, generally large institutions including some foreign banks such as Barclays, Deutsche Bank, HSBC, MUFG Union Bank, Santander, and UBS. Those institutions have made major investments over the years in the computer systems needed to interface with and support the TCH payment system. Smaller institutions, e.g., community banks, access the TCH system through Clearing House banks. In 2017, TCH launched its Real-Time Payments (“RTP”) system which provides a 24 hour/7 days a week/365 days a year RTGS system for participating banks, including a payment service that supports instant payments. The TCH system is very complete, but it does not (at least as of now) have real-time reporting capabilities for all US banks. As FRB Chair Jerome Powell has said, the RTP network “is far behind other countries in terms of having real-time payments.” The RTP provides “instant payment” through a joint account at the Federal Reserve Bank of New York. That joint account is owned by the Clearing House banks and must be prefunded with sufficient balances to maintain the ability to fund instant settlements. Nonetheless, one can understand that the Clearing House banks and the TCH do not look favorably on the FRB’s effort to create FedNow Service with public money to compete with, and notionally, to replace the TCH system. Although the FRB concluded in their August 6 announcement that FedNow Service would have “no direct and material adverse effect” on the RTP’s ability to compete.

The Proposed FedNow Service

On August 6, 2020, the FRB announced the details of its long-planned payment system to rival and perhaps eventually replace TCH. FedNow Service is to be an RTGS system with integrated clearing functionality that will offer 24 hour/7day a week/365 days a year payment processing for EVERY bank in the United States, resulting in instant payments, i.e. the end of Herstatt- and even daylight overdraft- risks. FedNow Service is now targeted to make its initial launch in 2023 or 2024. It will include a liquidity management tool (“FedNow LMT”), so that FedNow Service participants can transfer funds between accounts at the twelve Federal Reserve Banks to meet liquidity needs associated with instant payments. The August 6 announcement notes that the FRB plans a phased approach to implement this system, including pilot programs and providing additional features and functionality in the years following the initial launch. Some of the additional features and functionalities now envisioned include enhanced fraud prevention tools (such as central pattern-recognition monitoring systems), support for bulk payments, enhanced remittance information, and support for alias-based payments through application programming interfaces.

The FRB began a study of ways to improve the U.S. payment system in 2013, which led to the formation of the FRB’s Faster Payments Task Force. That Task Force resulted in a set of recommendations for improving the payments system in 2017. In 2018, the FRB sought comments on the FRB’s role, if any, in the U.S. payments system AND whether to develop FedNow, which in turn led to the FRB 2019 announcement that it would develop FedNow Service and then issued a proposal for comment. The August 6 announcement was intended to “flesh out” the details of the initial FedNow Service. Ongoing steps will include developing needed infrastructure, integration (where possible and appropriate) with existing systems, and continuing discussions with banks and others on features and design decisions. The FedNow Service will use ISO 20022, the internationally developed messaging standard for financial services, with at least three message types:

  1. Credit transfers (payments)

  2. Return transfers (so-called “exception processing”)

  3. Interbank funds transfers (liquidity management-related transfers)

Timelines, pilot programs, fee structures, and governing terms are to be announced over the next couple of years. It is also worth noting that the FRB’s 2019 proposal set a transaction limit of $25,000 during the initial FedNow Service, that limit is not contained in the August 6 announcement. FedNow Service envisions operations with a daily closing time of 7:00 p.m. Eastern Time, which will be consistent with the FedWire Funds Service when it shifts to a 7:00 p.m. closing time beginning in March 2021. “End-of-day” balances will be calculated each day (including weekends and holidays), with a seven-day accounting regime, a significant change from the current five-day accounting regime. The August 6 announcement also sets out an optional five-day work-around for smaller banks which do not wish to make the investment necessary to support a seven-day accounting system.

The FRB in its August 6 announcement expressed concerns about having only one payment system for a number of reasons:

  • The inertia inherent in the RTP system with its legacy components

  • The potential loss of innovation and pricing improvements from the competition

  • The national security implications of a single payment system, particularly in the face of a cyber attack

As of now, only the following will be eligible to participate in the FedNow Service:

  • U.S. depository institutions

  • U.S. branches of foreign banks

  • Designated financial market utilities

  • The U.S. Treasury

  • GSE’s (such as Fannie Mae and Freddie Mac)

  • Certain multilateral development banks

  • Non-U.S. countries

  • Other central banks

Non-banks such as payment companies cannot directly participate, but they may serve as service providers or agents for eligible participants. U.S. banks do not have to participate in FedNow Service, although if the features contemplated are in fact offered one may wonder how bank supervisory authorities will assess the quality of bank management in an institution that elects not to participate.

The FedNow Service has now completed its seven-year incubation. As implementation begins, there are sure to be many hurdles and unexpected developments, but the path is now set. Let the rivers of financial transactions, and the reporting of them, flow.

 

NLR Logo

We collaborate with the world's leading lawyers to deliver news tailored for you. Sign Up to receive our free e-Newsbulletins

 

Sign Up for e-NewsBulletins